The cash of last resort

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  • The cash of last resort
  • The cash of last resort

Gold could be the asset class that puts the long-term shine back in pension fund investments, says Pirkko Juntunen

Economic gloom is tightening its grip on the global investment environment and investors are searching for viable alternatives. One of these has been commodities for the past few years, with prices soaring skyward. One precious metal in particular that has caught the attention of investors of late is gold.

Investments in gold, both securities and physical holdings, have been increasing, according to statistics from the World Gold Council, with investors buying 72 tonnes of gold via exchange traded funds in the first quarter of this year. The range of investment products in gold has also increased and now includes coins and small bars, exchange traded gold, gold accounts, gold certificates, gold-oriented funds and structured products. In March the gold price reached a peak of $1011 per ounce, while as of June, trading remained well above last year's average of $695.39/oz.

At the same time as the price soared, the dollar fell to record-lows, and many saw this as a good indicator of a time to invest in gold as a safe haven and insurance against continued downturns in equity and bond markets, as well as a dollar hedge.

Dennis van Ek, (pictured right) principal of Mercer Investment Consulting in Amsterdam, has done extensive research on gold as an asset class for pension funds.

He argues that it is a viable alternative, but not just investing though funds or ETFs.

He also favours a scenario whereby gold will not peak until 2015, as cycles tend to last between 15 and 20 years. He says the advantage of physical gold, compared with funds, ETFs or other investment vehicles, is that it has no a credit risk because it does not represent anyone's liability. "There is no risk that a coupon or a redemption payment will not be made, as for a bond, or that a company will go out of business, as for an equity," says Van Ek. "And unlike a currency, the value of gold cannot be affected by the economic policies of the issuing country or undermined by inflation in that country."

He says that to understand the arguments for investing in gold it is important to understand money, currency, inflation and deflation. He explains: "Money is gold and silver. Under a gold standard, the currency is fully backed by gold. Fractional currency and fiat currency are either partially or not covered by gold or silver. Nowadays our money system is based on paper, which represents paper claims on the underlying value of euros and dollars on the Central Banks of Europe and the US.

Before the end of the Bretton Woods system all these paper claims were honoured in gold. In 1971 the US government ended the possibility of conversion of US federal-reserve notes to gold. This meant that the US defaulted on its promise to foreigners to have 35 US federal-reserve notes exchanged for 1 ounce of gold. In fact, this marked a transition to a fiat money system.

"This means that from then on paper claims could be circulated without underlying value, with central banks adding more paper in the form of cash, or monetary inflation, and credit, or credit inflation," continues Van Ek. "This fiat money system is now under pressure as a result of monetary inflation and credit expansion.

According to the European Central Bank's April bulletin, monetary inflation and credit expansion have averaged around 8% per annum over the past decade. The related bubbles in equities and real estate may burst further as a consequence of unsustainably high debt levels, lack of production and lack of value in the form of commodities and precious metals. In this scenario the reduction of debt load and the bubbles in debt-based assets will result in less credit, which could continue for the next eight-12 years," he believes.

Van Ek says that commodities, both hard and soft, can be observed to be in an upward cycle which started with oil in 1997, in 1999 for base metals and in 2002 for gold - with the cycle likely to continue for the foreseeable future. "The rise of gold is a direct result of the loss of ‘value' of fiat currency and the developments of the credit markets we're going through. Last year there was a credit crunch, which was followed by the current credit crisis, which may be followed by a credit contraction. If you believe that credit will continue to be scarce, and that monetary inflation will continue to be high, then gold will remain an attractive option. In this scenario debt-based investments will decline in value and precious metals will be favoured because of the pursuit of value."

Van Ek has a Dutch pension fund client that has already invested €15m through the Perth Mint in Australia and he is assisting two Dutch pension fund boards with the development of their future vision on the markets, possibly leading to a similar strategy.

"The Federal State of Western Australia carries its own currency, a gold coin. This is legal tender there, as well as the more familiar Australian paper dollar. The government-guaranteed gold investment programme has existed since 1899, and is the only one in the world. The gold is fully allocated and insured through the Lloyd's of London," he explains.

There are two ways of investing at Perth Mint. One is ‘unallocated', where you hold a certificate of your holdings and the other is ‘allocated', where you hold physical gold, and where there is 100% guarantee that the investment is covered by gold. "In fact, if you wish to, you can visit the Perth Mint in Australia and take a look at your gold," Van Ek says.

He argues that allocated gold investment in Australia may offer an advantage in extreme scenarios, such as government intervention as in the 1930s, because the investment would likely be beyond the reach of the US and European governments. Van Ek concludes: "Gold is the cash of last resort," he notes. Evy Hambro, managing director at Blackrock and co-manager of a $8bn (€5.1bn) gold fund, the biggest in the world, and Daniel Sacks, a Cape Town-based fund manager of Investec Asset Management's $330m gold fund, argue that the fundamental drivers of supply and demand also favour gold investment, not just the current financial turmoil.

Sacks says that production in South Africa has halved during the past 10 years. He says new gold deposit finds elsewhere are not large enough to make up the difference and are also difficult to play for fund investors. Hambro says production continues to fall because of the age of the mines, largely built in between the 1940-60s, where gold deposits are shrinking and supply is not meeting demand. Hambro notes that some of the biggest buyers of gold have been central banks from emerging markets in the East whereas Western central banks have been net sellers. "There is an interesting transfer of wealth going on," he says.

Nicholas Brookes, head of research and investment strategy at ETF Securities, argues that investing in gold via exchange traded funds makes the metal more accessible than investing in physical gold, but has the advantage of being backed by gold in vaults, compared to funds, which tend to hold mining companies and other related stocks rather than the metal itself. He says pension funds should invest in gold both for structural and tactical reasons.

Brookes does not see the current crises ending anytime soon and believes that gold is a sensible investment for investors, such as pension funds, with a long-term investment view.

"It makes sense for long-term investors to invest in gold as a diversifier, and ignore the sharp swings in short-term prices. Research has shown that the most important investment decision is asset allocation rather than market timing, so getting
the asset mix right is vital and commodities and gold definitely belong in an institutional portfolio," Van Ek concludes.

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